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COMMISSION OF THE EUROPEAN COMMUNITIES
Brussels, 14.10.2009
COM(2009) 545 final
COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN
PARLIAMENT AND THE COUNCIL
Long-term sustainability of public finances for a recovering economy
{SEC(2009) 1354}
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COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN
PARLIAMENT AND THE COUNCIL
Long-term sustainability of public finances for a recovering economy
1.
INTRODUCTION
1.
This Communication and its companion Report (Sustainability Report 2009) assess
the sustainability of public finances in the EU Member States. It is an update of the
communication and report of 20061, following the request of the ECOFIN Council of
November 20062, which asked the Commission to prepare a new sustainability report
when new common age-related expenditure projections become available in 2009.
The Communication is issued in the context of the reflection on strategies to exit
from the economic and financial crisis and on the convergent and coordinated
framework for the reform of Europe's economies at the core of the strategy for
Europe 2020.
2.
The report takes into account the context of the financial and economic crisis and its
impact on public finances at the moment when the first signs of stabilisation become
apparent. As long as the recovery is not sustained and the discretionary measures
deployed by governments are not withdrawn, the effect of the crisis on public
finances cannot be fully determined. However, given the large impact of the crisis on
public debt, this communication provides a timely input at a stage where, in line with
the European Council position: ‘fiscal policies must progressively be reoriented
towards sustainability’ and ‘exit strategies need to be designed now and implemented
in a coordinated manner as soon as the recovery takes hold, taking into account the
specific situation of individual countries’3.
3.
The regular assessment of fiscal sustainability is in line with the reformed Stability
and Growth Pact (SGP), according to which long-term issues should get a prominent
role in surveillance. Recently, Member States have agreed detailed principles on the
revision of the medium-term budgetary objectives (MTO) in order to ensure that the
Member States’ budgetary strategies reflect real medium-term needs, by taking
account not just of debt levels but also implicit liabilities, notably costs related to
ageing populations, in particular projected healthcare and pension expenditure.
2.
AN ACUTE CHALLENGE AFTER THE CRISIS
4.
The European economy is showing signs of entering a phase of recovery after a
deep crisis. Thanks to effective and substantive policy action since autumn 2008,
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‘Long-Term Sustainability of Public Finances in the EU,’ European Economy, 4/2006 and Commission
communication - COM(2006) 574, 12.10.2006.
Council Conclusions on ‘The Sustainability of Public Finances,’ 7 November 2006.
Informal meeting of EU heads of State or Government, ‘Agreed language for the Pittsburgh G-20
summit’, Brussels 17 September 2009.
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coordinated in the context of the EERP4, a financial meltdown and a generalised loss
of confidence has been avoided. However, uncertainty remains high, and there are
still risks of negative feedback loops between the financial sector and the real
economy. Given the output losses in previous quarters, economic activity is set to
shrink by 4 percent this year, while growth in 2010 will be slim.
5.
Fiscal policymaking has been successfully targeted to the need and urgency of
pulling the economy out of the recession. Discretionary fiscal stimulus and
unfettered automatic stabilisers have provided a cushion to economic activity and
contributed to the recent signs of improvement, but have led to a substantial
deterioration in government accounts. From a deficit of 0.8 percent of GDP in 2007 –
the best result for thirty years – the government deficits in the EU are forecast to
average 6 percent of GDP in 2009 and around 7 percent in 2010. In the three years to
2010, the gross debt ratio for the EU as a whole is increasing by more than 20 points.
Moreover, exceptionally large contingent liabilities may translate into actual costs
over the coming years, although some costs in support of the banking sector may be
recouped.
6.
The sustainability of public finances in a longer-term perspective must not be
ignored. Though the debt and deficit increases are by themselves quite impressive,
the projected impact on public finances of ageing populations is anticipated to dwarf
the effect of the crisis many times over. The fiscal costs of the crisis and of projected
demographic development compound each other and make fiscal sustainability an
acute challenge. The available projections show that, in the absence of ambitious
efforts to implement structural reforms and consolidate government accounts, there
would be very large increases in expenditure on debt interest and public pensions, as
well as on healthcare and long-term care during the coming decades.
3.
HOW TO ASSESS LONG-TERM SUSTAINABILITY OF PUBLIC FINANCES
7.
Sustainability relates to the ability of a government to assume the financial
burden of its debt in the future. There is no defined upper limit to sustainable
debt levels. Limits to sustainability differ across countries and time. The capacity to
run high debts depends inter alia on the degree of development of financial markets,
perceived risks, and trust in the capacity of a government to implement structural
reforms and consolidate deficits. It also depends on the degree of global risk aversion
and investments alternative to government bonds. However, countries with high debt
ratios – as well as large external imbalances or contingent liabilities – are particularly
exposed to market turbulences, such as changes in interest rates and spreads during
times of evolving economic perspectives.
8.
A one-off increase in the stock of government debt need not put sustainability at
risk. Fiscal expansion in a crisis context is not detrimental for sustainability as long
as the measures adopted by governments are temporary and phased out when the
recovery is secure. Concerns arise from the structural nature of high deficits, and
because, without an adequate structural reform strategy, the crisis may have a
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‘European Economic Recovery Plan,’ communication from the Communication to the European
Council - COM(2008) 800, 26.112008.
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durable impact on output and potential growth, which overlaps with the secular
slowdown in GDP growth and the rise in expenditure on account of the demographic
trends.
9.
Fiscal policy is not sustainable if it implies an excessive accumulation of
government debt over time – now or in the foreseeable future – and ever-increasing
debt service. Sustainability requires the avoidance of an excessive increase in
government liabilities – a burden on future generations – while ensuring the
government’s capacity to deliver the necessary public services, including the
necessary safety net in times of hardship, and ability to adjust policy in response to
new challenges.
10.
In order to analyse whether, based on current policies, government finances are
sustainable, a long-term perspective is thus necessary. The assessment is based on
long-term projections5 of government expenditure, revenue and deficit that take into
account expenditure drivers such as demographics and debt accumulation. To
quantify the sustainability risks of the Member States’ public finances, the
established concept of sustainability gap is used. This indicator measures by how
much tax or spending would need to be adjusted, now and in a lasting manner, to
ensure that the government debt remains within manageable limits over the
projection horizon. However, a complete assessment also requires the consideration
of a series of other indicators, such as the current debt, contingent liabilities, the
stock of government-owned assets, the tax burden, the projected evolution of average
pensions and the performance of private funded pension schemes, the developments
in the sustainability gaps in case no action is taken, as well as the possible
reinforcement of social protection in some countries.
11.
An increase in debt ratios in the coming decades is avoidable, and policy measures
can and should be taken to escape a trend of increasing debt. The long-term scenarios
– under unchanged policies, therefore not including measures that governments may
be considering but that have not yet been adopted – in the companion report show a
relentless increase in debt ratio over the coming decades. These scenarios allow an
assessment of the risks Member States are confronted with, but they are not
inevitable. Unchanged policy scenarios are state-of-the-art for long-term
sustainability assessments, but they are not realistic forecasts in any country. Those
scenarios are useful to illustrate the size of the policy action that is necessary to
ensure sustainable public finances, and show the outcome if no action was taken.
This approach, already used in the Sustainability Report of 2006, was endorsed by
the ECOFIN Council of November 2006, which concluded that such a report should
be the basis for the assessments of long-term sustainability in the context of annual
stability and convergence programmes.
12.
The assessment of the long-term sustainability of fiscal policy is now a well
established part of budgetary surveillance in the EU. However, in a context of crisis
and recovery, the sustainability assessment is undertaken under larger than
usual uncertainty. On the one hand, it is difficult to correctly judge the initial
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‘2009 Ageing Report,’ joint report of the Commission and the EPC, European Economy, 2, and
Commission communication ‘Dealing with the Impact of an Ageing Population in the EU’ COM(2009) 180, 21.42009.
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structural fiscal position in 2009. This is related to the uncertainty on the potential
output and the output gap, but also on the way that tax revenue has been affected by
the crisis, as well as on the durable or temporary nature of the support measures
adopted by governments. In so far as the temporary measures taken in the context of
the crisis have not be fully filtered out of structural deficits, the sustainability risk
may have been overestimated. On the other hand, if growth-enhancing reforms are
not adopted, the crisis may have a protracted impact on the way our economies will
grow over the next decade; in this case, the baseline sustainability indicators in the
companion report would underestimate risks.
4.
ASSESSMENT OF SUSTAINABILITY BY COUNTRY
13.
The long-term sustainability of the public finances and the budgetary impact of
ageing populations is a concern for all EU Member States. However, there are large
variations across the Member States in terms of the degree of long-term risk that they
are exposed to and the sources of that risk. This variation results from: (i) differences
in their initial budgetary positions in 2009 for general government, including the debt
level and the structural deficit; (ii) differences in the financing and scope of social
protection systems (iii) differences in potential growth that result from their relative
levels of development and the projected demographic developments.
14.
On the basis of the quantitative sustainability indicators6, the sensitivity analysis of
the underlying assumptions and additional factors, such as debt, government assets
and pension projections, an overall assessment of the long-term risks to public
finance sustainability the different Member States might face is reached 7. Based on
this methodology and following the approach developed in the 2006 Communication,
and as presented in that communication and endorsed in the ECOFIN Council
conclusions of November 2006, Member States are classified into categories
depending on the degree of long-term risks they faced and where these risks mainly
come from. In its conclusions the Council also considered that the categorisation
used in the sustainability report provides an important tool to assess the sustainability
challenges that Member States are facing.
15.
Bulgaria, Denmark, Estonia, Finland and Sweden have relatively stronger
budgetary positions and have undertaken comprehensive pension reforms in recent
years. Though the crisis is leading to a deterioration in government balances and a
substantial increase in government debt ratios of each of these countries, their
structural fiscal positions remain sounder than in most other EU countries and
present, therefore, a low long-term risk. In Bulgaria, Denmark, Estonia and Sweden,
the increase in age-related expenditure over the next decades is projected to be well
below the EU average. In Finland, the projected increase in expenditure is substantial
and the fiscal cost of the crisis has been large. However, the large stock of financial
assets in the social security portfolio provides a cushion to absorb a deterioration in
government accounts.
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Sustainability indicators assume age-related expenditure (pensions, healthcare, long-term care,
unemployment and education) will evolve in line with demographic projections, and the constancy of
the ratio-to-GDP of revenue and other primary expenditure.
The companion report contains a detailed explanation of the methodology used and of the different
alternative scenarios.
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16.
Belgium, Germany, France, Italy, Hungary, Luxembourg, Austria, Poland and
Portugal are countries with very different characteristics in relation to their initial
budgetary position and age-related expenditure. Belgium, Germany and Austria are
projected to bear costs of ageing close to, or above, the EU average, but their initial
budgetary positions are relatively sound, provided that the crisis-related deterioration
in government accounts does not become structural. Though medium-term
consolidation will improve the sustainability indicators, reforms to address rising
age-related costs will be indispensable. For Belgium, the debt ratio – which is
returning to above 100 percent of GDP – constitutes a burden and a specific risk. The
projected increase in the age-related expenditure in Luxembourg is the highest of the
whole EU; however, this risk is cushioned by the currently low debt and large
government-owned financial assets.
17.
For France, Italy, Hungary, Poland and Portugal, the long-term costs of ageing are
not projected to be particularly high. However, their initial budgetary positions imply
that fiscal policy is unsustainable even without considering any increase in agerelated expenditure. In all these countries, the crisis and the support to recovery are
leading to a very fast increase in debt ratios, quickly offsetting the consolidation
gains achieved in recent years. For Poland, projections indicate a fall in age-related
expenditure over the long term because of the shift of pension provision to funded
schemes; however, the projected reduction in expenditure is also related to a large
cut in benefit ratios. This may raise issues of pension adequacy and increase old-age
poverty. For France, ambitious fiscal consolidation, once the recovery is firmer, is
indispensable and will constitute a major step to improve sustainability. In Portugal,
a recent pension reform have done much to improve sustainability; however, the
structural budgetary position remains largely unbalanced. In the case of Italy, fast
fiscal consolidation once the recovery takes hold is indispensable to ensure a steady
reduction in the very high debt ratio8. The low sustainability gap of Hungary results
from pension reform and recent fiscal consolidation; however, the correction in
structural imbalances in recent years needs to be pursued further in order to reduce
debt. In general, for this group of countries the long-term sustainability risk is
medium.
18.
The sustainability gaps of Czech Republic, Cyprus, Ireland, Greece, Spain,
Latvia, Lithuania, Malta, the Netherlands, Romania, Slovenia, Slovakia and the
United Kingdomare all above 6 percent of GDP; over double that level in Ireland,
Greece, Spain, Slovenia and the United Kingdom. In nearly all of these countries, the
sustainability gaps are the result of a very large projected increase in age-related
expenditure, compounded in most cases by large initial imbalances, and hence they
are exposed to a higher long-term risk. This indicates that closing their gaps will
require both ambitious consolidation programmes that reduce debts and deficits in
the coming years, and profound reforms of social protection. This is particularly the
case for Greece, which faces the second highest increase in age-related expenditure
of the entire EU, while its very high debt ratio adds to the concerns on sustainability.
The possible continuing effects of the crisis on the budgetary position and on
medium-term growth are a serious concern for most of the high risk countries – in
particular, Ireland, Greece, Latvia, Spain and United Kingdom – for whom avoiding
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This is projected to be above 116 percent of GDP at the end of 2010 – the highest ratio since the
creation of the euro.
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a very fast increase in debt ratios is a policy challenge already in a medium-term
perspective.
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19.
In many countries, there has been a deterioration in sustainability in
comparison with previous assessments. Compared with the 2006 situation, the
sustainability gaps are larger in most countries and ten of them (Ireland, Spain,
Latvia, Lithuania, Malta, the Netherlands, Austria, Poland, Slovakia and the United
Kingdom) are now in a higher risk category. In the case of the countries most hit by
the crisis, the deterioration in sustainability gaps is particularly severe. However,
thanks to consolidation and pension reform, Hungary and Portugal have shifted from
the higher to the medium-risk group of countries.
5.
SUSTAINABILITY
CHALLENGES
20.
The crisis-related deterioration in public finances and the projected increase in
expenditure due to demographic change both constitute major policy challenges.
Given the current budgetary situation, the projected changes in population structure
and the long-term scenarios for economic growth, the government debts of many
countries will experience significant increases. Though interest rates are currently
low, soaring government bond issuance will put upward pressure on rates as the
economies emerge from crisis and crowd out investment. Public finances, including
social protection systems, have cushioned the economic and social impact of the
crisis. Notwithstanding the need to keep supporting the economy and avoid choking
an emerging recovery, measures to improve fiscal sustainability, identified in
Member States’ stability and convergence programmes, should be implemented in a
decisive manner as soon as conditions allow it, to avoid a more severe correction at a
later stage.
21.
High debt ratios in the past have often been corrected by fast economic growth. With
demographic developments negatively affecting potential growth, the importance of
productivity-enhancing reforms will further increase. The reduction in debt ratios
will have to come from a combination of fiscal consolidation and structural
reforms to support potential growth.
22.
A fast and unsustainable increase in government debt in the coming decades can
be avoided. The strategy to prepare for the economic implications of the
demographic changes has been in place since the 2001 European Council of
Stockholm. This strategy includes (i) deficit and debt reduction, (ii) increases in
employment rates and (iii) reforms of social protection systems. It has shown its
validity and remains applicable. Yet, the macroeconomic situation created by the
crisis has changed the context, the way such a strategy may be applied, the relative
weight of its components and the urgency of its implementation. While, prior to the
crisis, the three prongs of the strategy were options from which countries could
choose, each of these pillars is now indispensable for most EU countries.
23.
The first element of the sustainability-oriented strategy refers to the need to reduce
debt, by reaching and sustaining sound underlying budgetary balances. In the decade
prior to the crisis, ambitious consolidation was successfully implemented in several
countries. The Member States that reached their MTOs in line with the SGP
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FINANCES FOR A
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managed to reduce their debt ratios substantially and improved their sustainability
indicators. This provided them with a new-found leeway to implement a countercyclical expansionary policy when the crisis came into full force in the second half of
2008.
24.
Simply overcoming the ongoing economic and financial crisis without fiscal
consolidation in a determined manner will not suffice to bring government debts to a
sustainable path. Projections based on a scenario of growth returning to the long-term
path of before the crisis show that without consolidation, the gross debt-to-GDP ratio
for the EU as a whole could reach 100 percent as early as 2014, and keep on
increasing. A consolidation effort of 0.5 percent of GDP per year until the Member
States’ MTOs are reached9 will only stabilise the debt ratio at around 100 percent of
GDP if growth takes time to return to the pre-crisis trend. Thus, although fiscal
support must be maintained until recovery is secured, fiscal policies must
progressively be reoriented towards sustainability.
25.
A fast reduction in the debt ratio will also depend on an orderly disposal of assets
accumulated in support of the financial sector, and an effective management of
contingent liabilities10. The appropriate withdrawal of public-sector support measures
for the financial sector must reconcile the need to safeguard financial stability with
the medium-term goal of returning the sector viability and competitive market
functioning, and protecting taxpayers’ interests in line with state aid policy.
26.
The second leg of the strategy concerns increasing employment rates. Structural
reforms, in particular aiming at improving the functioning of labour markets, have
contributed to raising employment rates among older workers and women, and to
increase growth potential. The increase in employment rates prior to the crisis was an
important step towards sustainability, by counteracting some of the effect that a
reduction in the working age population would have on growth. At the current time,
where employment is contracting and unemployment is rising, there is a need to
avoid cyclical unemployment becoming entrenched, an increase in long-term
unemployment and a reduction in participation rates. There is a broad consensus on a
set of European principles11 to mitigate the impact of the crisis, shape a lasting
recovery and contribute to potential growth in a longer perspective: it is important to
prioritise measures aimed at reducing the costs of adjustment and speeding up
transitions in the labour market. Policies should be in synergy with the social goals
of supporting the income of the most disadvantaged citizens, which in itself will
assist stimulating aggregate demand. Short-term policies to address the crisis
should not run counter to long-term reform strategies, including the implementation
of the flexicurity principles under the Lisbon Strategy. In particular, Member States
should refrain from using policies such as early retirement schemes in order to
mitigate the impact of higher unemployment and industrial restructuring. In euroarea countries, labour-market policies should also facilitate structural adjustment, in
particular with regard to addressing significant divergences in external
competiveness, through their impact on unit labour costs.
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That is the benchmark consolidation rhythm in the SGP.
Guarantees to bonds or loans issued by banks, special purpose vehicles (‘bad banks’) and other entities.
‘Driving European Recovery,’ Commission Communication for the Spring European Council COM(2009) 114, 4.3.2009.
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27.
A key lesson of financial crisis in the past is the likely negative impact on potential
growth and the need for structural adjustment, reallocations and innovation to
counter it. Structural reforms thus have a crucial role to play in an overall strategy
designed to return economies to sustainable growth and fiscal paths. While being
tailored to the specific circumstance in each country, reform agendas to bolster
potential growth should include, not only the above-mentioned measures to improve
the labour markets and increase participation rates, but also a full exploitation of the
Single Market; reforms to improve the functioning of the EU’s knowledge triangle of
education, R&D and innovation, which contribute to technological developments and
productivity growth, and efforts in relation to green technologies.
28.
Reforms to social protection systems – the third element of the strategy – are
necessary. For many Member States, the primary surpluses that would be required to
reduce debt and ensure a full pre-funding of ageing-related cost are unrealistically
large. Those primary surpluses are well above the historical levels ever recorded in
EU countries, and would have to be sustained for very long.
29.
The main policy lever to ensure sustainability is through reform of pension and
healthcare systems. In relation to pensions, several reforming avenues are possible
and have been implemented or are being contemplated by several countries. These
range from, changes in the rules on the accumulation of pension rights, establishing a
better link between contributions paid during working life and pensions, increasing
statutory retirement age, tightening eligibility requirements and removing incentives
to early retirement. In several countries, future pensioners have been encouraged to
top-up their public pensions with their own savings and funded old-age income. Yet,
developments in financial markets during the crisis have illustrated the risks
associated with the shifting of a large share of pension provision to privatelymanaged funded schemes, and has reduced the political and social support to
implement reforms that leave a large proportion of pensions subject to market
fluctuations. The Commission will continue to work with the Council and the
Member States to identify lessons for the design of funded schemes and target
beneficiaries in order to secure adequate and sustainable private pension provision.
Each country will have to identify the reforms that better fits its own characteristics
and social preferences and consensus will be desirable to implement them. Increases
in the effective retirement age that reflect gains in longevity are being
contemplated in several Member States and merit wider consideration. On top
of savings to government expenditure in a medium- to long-term horizon, an increase
in the statutory and effective retirement ages contributes to increase the working
population and stem the deceleration in potential output. Moreover, the extension in
working life and the respective accumulation of pension rights will have a favourable
impact on pensioners’ income.
30.
The projected long-term increase in healthcare spending is large and constitutes
on its own a risk to sustainability. Given the complex and hardly predictable
mechanisms of progress in medical technology, which have accounted for a
considerable share of expenditure growth, the projections may even underestimate
future spending. Moreover, for some countries, a need to improve the quantity and
quality of health services and to widen the coverage of formal long-term care
provided to elderly may add further pressure on public finances. Given its
multidimensional nature, a reform of healthcare needs to consider several complex
issues, on ways to make health system more efficient; on the resources allocated to
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preventive and curative medicine; on responding to the challenge of maintaining an
appropriate healthcare workforce; on the balance of financing between patients,
public and private insurers; the degree of competition among providers of care; on
the effective assessment and management of technology aiming at fostering
efficiency and ensuring high-quality services while rationalising costs; or ethical
issues like access to expensive treatments.
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31.
As public resources are scarce, an increase in the quality of public finances is
indispensable. Modernising public services and reducing non-productive
expenditure helps stemming the debt increases, frees resources to invest in growthboosting areas such as education, research and innovation, and other policy
objectives (social, environmental, health) and strengthens incentives for raising the
productive capacity of the economy. Fiscal consolidation through raising additional
revenue should take account of incentive effects, efficiency and competitiveness, be
focused on those measures with the least distortionary effects, in particular on labour
participation and capital accumulation, while contributing to meeting other goals
(e.g. green taxes). .
6.
CONCLUSION
32.
The available long-term projections show that, in the absence of an ambitious effort
to consolidate government accounts and structural reforms, there would be
unbearable increases in debt interest and pension expenditure, as well as on
healthcare and long-term care during the coming decades. Rising government
expenditure and prospects of an ever-increasing debt would be an obstacle to a
sustained and long-lasting recovery and balanced economic growth.
33.
Successful fiscal expansion to counter recession and longer-term fiscal
sustainability are not incompatible. Fiscal measures to increase confidence and
support demand are only successful if they are perceived by the markets and public
opinion as temporary and consistent with long-term sustainability. Otherwise, if
economic agents expect a durable widening of debt, fiscal support will lose its
effectiveness and can become counterproductive, in particular when the crisis climax
has been overcome and one enters a phase of recovery.
34.
Past experiences show that, by illustrating the need and urgency of structural
reforms, crises constitute a window of opportunity that governments can use to make
decisive breakthroughs in structural reforms. Fiscal exit strategies aiming at
achieving ambitious and realistic medium-term objectives need to be designed now,
and implemented in a coordinated manner as soon as recovery takes hold, taking into
account the specific situations of individual countries. To support the required
reforms and enhance the credibility of fiscal adjustment – which inevitably stretches
over a number of years – Member States may also need to develop further their own
stability-enhancing institutional arrangements. In the Stability and Growth Pact
context, debt sustainability should get a very prominent and explicit role in
surveillance procedures.
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35.
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It is in the context of the sustainability challenge and the need to support the nascent
recovery that the Commission has recommended the correction of imbalances in
those countries that are currently in a situation of excessive deficit. It is also in this
perspective that Member States should set out ambitious and realistic targets in their
stability and convergence programmes. These are expected to give a specific
attention to sustainability-oriented strategies.
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